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7 Common Questions About Startup Employee Stock Options

Jim Wulforst is president of E*TRADE Financial Corporate Services, which provides employee stock plan administration solutions to both private and public companies, including 22% of the S&P 500.

Perhaps you’ve heard about the Google millionaires: 1,000 of the company’s early employees (including the company masseuse) who earned their wealth through company stock options. A terrific story, but unfortunately, not all stock options have as happy an ending. Pets.com and Webvan, for example, went bankrupt after high-profile Initial Public Offerings, leaving stock grants worthless.

Stock options can be a nice benefit, but the value behind the offer can vary significantly. There are simply no guarantees. So, whether you’re considering a job offer that includes a stock grant, or you hold stock as part of your current compensation, it’s crucial to understand the basics.

What types of stock plans are out there, and how do they work?

How do I know when to exercise, hold or sell?

What are the tax implications?

How should I think about stock or equity compensation relative to my total compensation and any other savings and investments I might have?

1. What are the most common types of employee stock offerings?

Two of the most common employee stock offerings are stock options and restricted stock.

Employee stock options are the most common among startup companies. The options give you the opportunity to purchase shares of your company’s stock at a specified price, typically referred to as the “strike” price. Your right to purchase – or “exercise” – stock options is subject to a vesting schedule, which defines when you can exercise the options.

Let’s take an example. Say you’re granted 300 options with a strike price of $10 each that vest equally over a three-year period. At the end of the first year, you would have the right to exercise 100 shares of stock for $10 per share. If, at that time, the company’s share price had risen to $15 per share, you have the opportunity to purchase the stock for $5 below the market price, which, if you exercise and sell concurrently, represents a $500 pre-tax profit.

At the end of the second year, 100 more shares will vest. Now, in our example, let’s say the company’s stock price has declined to $8 per share. In this scenario, you would not exercise your options, as you’d be paying $10 for something you could purchase for $8 in the open market. You may hear this referred to as options being “out of the money” or “under water.” The good news is that the loss is on paper, as you have not invested actual cash. You retain the right to exercise the shares and can keep an eye on the company’s stock price. Later, you may choose to take action if the market price goes higher than the strike price – or when it is back “in the money.”

At the end of the third year, the final 100 shares would vest, and you’d have the right to exercise those shares. Your decision to do so would depend on a number of factors, including, but not limited to, the stock’s market price. Once you’ve exercised vested options, you can either sell the shares right away or hold onto them as part of your stock portfolio.

Restricted stock grants (which may include either Awards or Units) provide employees with a right to receive shares at little or no cost. As with stock options, restricted stock grants are subject to a vesting schedule, typically tied to either passage of time or achievement of a specific goal. This means that you’ll either have to wait a certain period of time and/or meet certain goals before you earn the right to receive the shares. Keep in mind that the vesting of restricted stock grants is a taxable event. This means that taxes will have to be paid based on the value of the shares at the time they vest. Your employer decides which tax payment options are available to you – these may include paying cash, selling some of the vested shares, or having your employer withhold some of the shares.

2. What’s the difference between “incentive” and “non-qualified” stock options?

This is a fairly complex area related to the current tax code. Therefore, you should consult your tax advisor to better understand your personal situation. The difference primarily lies in how the two are taxed. Incentive stock options qualify for special tax treatment by the IRS, meaning taxes generally don’t have to be paid when these options are exercised. And resulting gain or loss may qualify as long-term capital gains or loss if held more than a year.

Non-qualified options, on the other hand, can result in ordinary taxable income when exercised. Tax is based on the difference between the exercise price and fair market value at the time of exercise. Subsequent sales may result in capital gain or loss – short or long term, depending on duration held.

3. What about taxes?

Tax treatment for each transaction will depend on the type of stock option you own and other variables related to your individual situation. Before you exercise your options and/or sell shares, you’ll want to carefully consider the consequences of the transaction. For specific advice, you should consult a tax advisor or accountant.

4. How do I know whether to hold or sell after I exercise?

When it comes to employee stock options and shares, the decision to hold or sell boils down to the basics of long term investing. Ask yourself: how much risk am I willing to take? Is my portfolio well-diversified based on my current needs and goals? How does this investment fit in with my overall financial strategy? Your decision to exercise, hold or sell some or all of your shares should consider these questions.

Many people choose what is referred to as a same-day sale or cashless exercise in which you exercise your vested options and simultaneously sell the shares. This provides immediate access to your actual proceeds (profit, less associated commissions, fees and taxes). Many firms make tools available that help plan a participant's model in advance and estimate proceeds from a particular transaction. In all cases, you should consult a tax advisor or financial planner for advice on your personal financial situation.

5. I believe in my company’s future. How much of its stock should I own?

It is great to have confidence in your employer, but you should consider your total portfolio and overall diversification strategy when thinking about any investment – including one in company stock. In general, it’s best not to have a portfolio that is overly dependent on any one investment.

6. I work for a privately-held startup. If this company never goes public or is purchased by another company before going public, what happens to the stock?

There is no single answer to this. The answer is often defined in the terms of the company’s stock plan and/or the transaction terms. If a company remains private, there may be limited opportunities to sell vested or unrestricted shares, but it will vary by the plan and the company.

For instance, a private company may allow employees to sell their vested option rights on secondary or other marketplaces. In the case of an acquisition, some buyers will accelerate the vesting schedule and pay all options holders the difference between the strike price and the acquisition share price, while other buyers might convert unvested stock to a stock plan in the acquiring company. Again, this will vary by plan and transaction.

7. I still have a lot of questions. How can I learn more?

Your manager or someone in your company’s HR department can likely provide more details about your company’s plan – and the benefits you qualify for under the plan. You should also consult your financial planner or tax advisor to ensure you understand how stock grants, vesting events, exercising and selling affect your personal tax situation.

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